How Strong Currencies Can Kill Stocks

Be careful what you wish for.

Mention Switzerland to most people, and they'll probably think of chocolate, cheese, or watches. But with the big plunge in the U.S. stock market yesterday, many investors look at Switzerland as one of the last safe havens on earth for your money.

As it turns out, Swiss bank accounts have turned out to be one of the best cash investments you could have made so far this year. With the Swiss franc up around 30% against the U.S. dollar since last December, travelers who forgot to trade in their Swiss cash at the currency exchange booth at the airport are sitting on a windfall. In fact, the franc has performed so well that despite gold having seen record highs throughout the year in dollar terms, its price in francs is still well below its 2010 highs.

So if the Swiss currency is doing well, does that mean that you should jump into the Swiss stock market for smart buys as well? The answer may surprise you.

Looking at Swiss stocksSwitzerland sports a number of popular companies that you're quite familiar with. In fact, many of them trade on U.S. exchanges. Chocolate giant Nestle doesn't have a major listing in the U.S., but you can buy shares of major financial stocks UBS(NYSE: UBS) and Credit Suisse(NYSE: CS), drugmaker Novartis(NYSE: NVS), and agricultural company Syngenta(NYSE: SYT) all on the Big Board.

When you look at the performance of the iShares MSCI Switzerland Index(NYSE: EWL), however, you'll see that it isn't doing nearly as well as you might expect. So far in 2011, the ETF is up only 7% -- just a small fraction of the appreciation in the Swiss franc. Similarly, the closed-end Swiss Helvetia Fund(NYSE: SWZ) is up just 8% for the year. What's behind the disconnect?

The currency fallacyOn one hand, a strong Swiss franc is good for international investors in Swiss stocks. As long as the share price remains stable in francs, its value for international investors will rise in their home currency terms. For instance, all a Swiss stock would have had to do to earn U.S. investors a 30% return in dollar terms is to keep its price in francs the same. Currency effects would give U.S. investors all of their dollar gains.

But when you look at the Swiss stocks that make up the iShares ETF's holdings, you'll find that nearly all of them have lost money so far this year -- and many of them are down double-digit percentages. That's likely because what's good for international investors is bad for Swiss companies themselves. Nearly all of these companies get significant amounts of their revenue from business outside Switzerland -- business for which they get paid in currencies other than Swiss francs. So when Swatch (OTC: SWGAY) gets dollars from U.S. customers and euros from buyers throughout Europe, its earnings are held hostage to the exchange rates at which it can transform those foreign currencies back to Swiss francs. And while companies can hedge their currency exposure in the foreign exchange markets, they can't put off the inevitable forever.

A race to the bottomThe impact on trade is the reason why you've heard so much talk of "competitive devaluations" in the years since the financial crisis. As a strong currency makes it tough for companies that export from a particular country, weaker currencies give exporters a competitive advantage beyond their home markets. As a result, despite the detrimental effect that a weak currency has on consumers who rely on imports, a government might still choose not to follow a strong-currency policy in the hopes of helping export businesses.

So before you assume that anything Swiss will make a good investment in these difficult times, be sure that you understand the role that currencies play on stocks. As strange as it may seem, a strong currency could spell disaster for a country's stocks -- and for investors who buy them.

If you want to invest internationally, ETFs like the iShares MSCI Switzerland fund are very useful ways to get access to hard-to-reach markets. You should also look at the Fool's special free report, "3 ETFs Set to Soar During the Recovery," to find some great ETF ideas for your portfolio. All it takes to start is to click on the link.

Author

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.
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